Over the past two decades, banking has changed quite radically. We have seen the rise of interstate banking — first deregulation, then a flood of new regulation with numerous Basel Accords, the Financial Reform Bill and CFPB. Yet through all of this revision to banking, one component has remained static, until now.

That is asset-based lending; and in particular, the process of due diligence. This writer entered banking in the late 1980s and was one of the last to be trained on “old school” manual forms. Within the first year, banking began to use laptop computers.

In my 22 years within the industry, forms have changed from paper to computer, but little else. About the only other revision to analysis has been scope — prospects once involved a history of 24 months, now banks seem reluctant to go back 12. Frozen in time, we can observe the endangered “bankosaurus” in his shrinking habitat.

But what, of analysis, has evolved? Last year the FDIC passed the “Assessments, Large Bank Pricing,” where Deposit Insurance penalizes loans that may be declared “Highly Leveraged.” In the following months, the “Joint Interagency Guidance on Leveraged Lending” was written, and finally, the Office of the Comptroller of the Currency Examiner Handbook of ABL Lending was published.

Congress takes seriously the recent recession, and this level of gravity has been passed to Bank Regulators. The days of status quo are rapidly coming to an end for ABL and the larger Commercial and Industrial Lending (C&I) industry.

Is it possible that in time of record low interest income, record high industrial liquidity and a meteoric rise in competition now may be the time to revisit the entirety of “Due Diligence”?

We suggest that lenders first look at portfolios overall and ask “What triggers due any diligence?” A quick and likely answer is a matrix. Then, what makes up the scope? Again, the matrix. What is actually meant is the same criteria are carried, over decades (bankosaurus?). Yet the industry has moved — recently via regulations. A key difference in the larger banking industry now is the risk obsession. Each loan is assigned a risk value and with that, all the computations of reserves and capital.

Due Diligence Triggers

We now propose the primary trigger for due diligence be risk first and foremost (rather than structure). This elevates ABL, and the balance of C&I, to a standard equal to the rest of banking.

Purpose

What is the purpose of a collateral exam? This seems a silly question until the follow-up. “If an ABL department has collateral monitoring software, what is the purpose an auditor presenting receivable and payable comps?” If the average ABL loan has a relationship manager, ABL manager, collateral analyst, etc., why ask an auditor to perform financial statement analysis? How does such contribute to a better understanding of the collateral?

Again, what is the purpose of a collateral exam? What possible better time to revisit the entire process than now? Now is the time to become more efficient.

Most Important Components

A seemingly simple question, yet my most favorite answer is never given. Some say dilution analysis, others availability. Every possible answer to the question has a common component. All answers will rely on accurate accounting information. Therefore, it seems the most important item would be an accounting reconciliation. Is excess presence or lack of availability relevant when records are unreliable?

From a risk-based perspective, validating the accuracy of records is paramount. When looking at the recent and cited rules, I find another question: “Is the borrower able to report on a formula?” Remember: With the new leveraged lending guidelines, banks are penalized for highly leveraged transactions. This is bigger than the immediate ABL world, and is how ABL departments can increase in importance within a bank. Penalties from just a few large loans on the edge of “highly leveraged” may be sufficiently material to change a bank P&L. Are ABL departments now offering opinions on these large loans? With new regulations must come a modern and updated product from the ABL community.

What are the most important components of a typical collateral audit?

As previously mentioned, consider starting with the reconciliation. From there, if not an ABL deal, ask and answer this question: Can the company report with a formula? There are many reasons a borrower cannot. If reconciliation does not provide an answer, consider availability, dilution analysis and other testing.

Superfluous and Repetitive

What is the point of a collateral auditor presenting financial statement analysis? Remember, every element that can be legitimately omitted, at least occasionally, saves time and money.

Suppose the average ABL lender requires a borrower to submit a borrowing base certificate (BBC) before the general ledger is routinely closed. It is very possible the BBC is presented on preliminary, not final numbers. Then when financials are received, variances abound. Are such variances between the BBC and financial statement material? On average, banks we surveyed had a variance of about six percent, or just above the generally acceptable dilution level. If a lender finds this acceptable, what is the purpose of having examiners conduct the AR or AP comps?

From a risk based perspective, this becomes optional. If a lender desires to see the comps, refer to the ABL monitoring software. From a risk based perspective, one may eliminate analysis that serves no purpose. In my experience, we only sometimes say the comps serve no purpose. In such a case, eliminate the superfluous and become streamlined-efficient.

Varied Audit Scopes

Every client states they have varied scopes; is there an inventory loan, yes or no? If a bankosaurus is comfortable being out of touch with the industry, great! But for those lenders ready to embrace a more modern and reasonable approach, the rewards may be a more efficient and cost effective due diligence routine.

Treat the due diligence more like Legos; blocks that can be mixed and matched to address the risk, not structure.

When and how often is an inventory appraisal necessary? Can an appraisal alternate with an annual collateral? It depends on the exposure and circumstances.

I am now sitting with my team at a large borrower. The account has solid financial performance, a very low risk rating, and about 60% utilization. One of the audited months has dilution close to 20%. We also know four rebill invoices are 50% of the dilution with the balance being almost too many invoices to count.

Do we expend a minimum of six or more man-days (two days times with a three man team)? A bankosaurus will say yes. A risk-based approach may say to know the magnitude and reason. We will now watch routine reporting and modify the subsequent audits. Remember that every dollar saved is a dollar available to be deployed elsewhere. Redeploying some saved dollars here and there generally leads to an overall budgetary savings, even while improving oversight, where needed. Also, marketing and competitive pressures are such that superfluous and repetitive expenditures may cost a borrower to move.

One key to keeping regulators happy is to be consistent in how theories are deployed and I have yet to see a consistent deployment.

The old cliché, while worn, raises an interesting question: Can you teach an old ABL dog new tricks?

Timothy Alexander graduated from Loyola Marymount University and as an economist, entered banking. He was first with CIT Factoring and then with Sanwa Bank California. Next he went to The Mentor Group, a boutique firm providing contract due diligence. About two years ago, Alexander started Triune. The firm offers three services: contract due diligence (collateral audits and appraisals), liquidations and consulting services to both banks and regulators.